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Which Loans Should You Pay Down First?

Philosophies for paying off your debt
Is there a right or wrong way to pay down your loans? The answer is not cut and dried; it depends on your financial and personal goals and objectives.

Here are two main theories about the order in which you should pay off loans, along with further advice about each of those plans.

Theory No. 1: Highest interest rate first
The first school of thought is to pay off debts by interest rate from highest to lowest. The theory behind this is that it will save you the most money in the long run. This plan makes sense because debt with high interest is costing you much more money over time. The problem with this strategy is this: You may have more control over your finances, but you won’t feel as though you do.

Be aware — if your highest-interest loan is also your largest debt, it will take a while to pay it off. It may not look or feel as though you are making any progress for quite some time. This lack of satisfaction — not feeling that the debt is well on track to be paid in full — could make it more difficult to stay focused on your goal of paying off debt. That leads to the second intellectual outlook.

Theory No. 2: Smaller debts first
If you are into immediate gratification, this is the plan for you.

“You can clear up a lot of smaller monthly payments and quickly apply those to the extra money you are paying off on your debt snowball,” explains money management expert Miriam Caldwell, author of the online blog “Money in Your 20s.”

The downside here is that you could miss out on some important tax benefits of having big loans paid down, and you could end up paying a lot more interest in the end (see reasoning behind Theory No.1) by putting high-interest loans last in order of importance.

So what’s an embattled debt-payer to do?

Balance your approach
You may choose to intertwine the two methods. Start by knocking out a few of your small loans in the first couple of months, and then work on larger-interest debt before going back to paying on small loans again. Another way to balance out your methodology is to pay smaller loans off more quickly if their interest rates are generally within a percentage point or two, because that will give you more power (i.e., money) to pay off the larger loans.

“You may want to put the loans that save you on your taxes at the end of your debt payment plan. This would be your student loan, home equity loan or second mortgage,” suggests Caldwell. “These debts may also have lower interest rates. This lets you continue to deduct the interest from your taxes each year.”

She adds that you should never hold on to debt simply for tax purposes.

Stick to the plan
Eventually, the minimum payments may start to go down on debts such as credit cards. As tempting as it may be to use that extra money — those funds that you once had to put toward loan payments — on frivolous personal items, you must resist the urge. Use that extra money as an additional payment on your loans, using the same plan you started with initially to designate priority. This will help cut down your debt even more.

It may be hard to stay motivated, but you can do it! Create a chart so you can visually track your progress, or reward yourself at certain milestones with a small dinner out or a movie date. No matter what, remember that as long as you keep moving forward with a solid plan, progress is being made.

Used with Permission. Published by IMN Bank Adviser Includes copyrighted material of IMakeNews, Inc. and its suppliers.